Understanding a Personal Guarantee
Before you get the funding you need for your small business, you may first have to sign a personal guarantee. Although it’s a common provision within a business loan’s fine print, a personal guarantee can put your family’s finances in jeopardy.
What is a personal guarantee?
A personal guarantee is a provision a lender puts in a business loan agreement that requires owners to be personally responsible for their company’s debt in case of default. Lenders often ask for personal guarantees because they have concerns over the credit history, age or financial stability of your business. Each of these situations presents a certain level of risk for the lender. A personal guarantee lessens that risk.
Your business entity also plays a role in how debts are handled:
- Sole proprietorships have the fewest protections — you and your business are legally the same. A sole proprietorship is the most common business type.
- The type of partnership determines the level of liability. Owners in a general partnership are responsible for business debts while limited partners may be shielded. A limited liability partnership provides protection for all partners. However, if a partner signed a personal guarantee, they could still be held personally liable.
- Limited liability corporations (LLCs) are designed to separate you from your business, but if you signed a personal guarantee on business loans, leases or contracts, you’re promising to pay if your business cannot.
- C corporations or S corporations are separate legal entities but if an owner were to sign a personal guarantee or contract in their own name, like a partnership, they would personally guarantee the loan.
Takeaway: If you sign a personal guarantee, that might trump other protections your business entity provides.
Types of personal guarantees
There are two main types of personal guarantees: limited and unlimited. The difference between the two centers on the extent of your liability and how long the guarantee applies.
Unlimited personal guarantees
An unlimited guarantee — also known as an unconditional guarantee — means guarantors are required to pay all amounts due until the note is paid in full. The Small Business Administration (SBA) may require an unconditional guarantee, or unlimited full guaranty, from owners with a 20% or greater stake in a business applying for an SBA loan.
Limited personal guarantees
A limited personal guarantee on the other hand may reduce the dollar amount, time and/or percentage of the loan for which you’re liable. An SBA loan’s limited guaranty, for example, includes the following options for when a guarantor is released from liability:
- Balance reduction: when the balance drops below a certain dollar figure
- Principal reduction: when the loan principal drops below a certain dollar figure
- Maximum liability: when a set dollar amount is paid
- Percentage: when a set percentage of the loan plus interest and other costs is paid
- Time: when a maximum amount of time has lapsed
- Collateral: when provided collateral takes the place of a personal guarantee
- Community property or spousal interest: when property owned jointly between spouses or the spouse’s interest in pledged collateral is exempt from enforced collection.
‘Bad boy’ clauses
Bad boy clauses, also known as “carve-outs” are a conditional type of personal guarantee that kicks in when the borrower does something illegal or unethical. You’ll often see these included in commercial real estate contracts where violations may include:
- Misapplication of funds
- Unauthorized transfers of the mortgaged real property or other collateral
These clauses provide an extra layer of protection for the lender or leasing agency.
Personal guarantee: Should I sign?
Signing or agreeing to a personal guarantee may be the only way to get the business loan you need. It gives you an influx of cash, but it comes with several drawbacks that you should understand before you sign.
The main danger is that if your business defaults on the business loan, you are liable for the loan along with a potential family member, such as a spouse who may have been required to sign as well. It can also result in the following consequences:
- Your personal credit declines if you can’t make the payments
- You could lose any collateral tied to the guarantee (equipment, home, car)
- The lender can take your checking or savings balances if they were part of the collateral
In other words, you could go under if your business goes under.
Alternatives to a personal guarantee
You may be able to forgo a personal guarantee by offering collateral or increasing your collateral — a personal guarantee might only cover a certain percentage of the debt. If possible, it’s generally better to put up specific collateral for a loan instead of signing a personal guarantee and/or agreeing to a blanket lien against your business.
If a secured business loan isn’t an option, ask business partners or other owners to also sign personal guarantee loan agreements so that everyone is liable for their pro rata share. Or, ask them to sign an agreement to reimburse you should your personal assets be tapped. The goal is to reduce your personal liability as much as you can. Talk with your legal team to get a realistic sense of what you can bargain for.
“Many savvy businesspeople, even risk-taking entrepreneurs, studiously avoid (personal guarantees) because they could leave those individuals saddled with personal debt for years to come,” said New York City-based attorney John J. Thompson. “Consider it a ‘deal with the devil’. It’s often better to have your business fail than to begin incurring personal liability for your business’s costs or debts. You can always try again with a new business, but personal debt can follow you around for decades.”
Reduce the risk of a personal guarantee
If you decide to move ahead with a personal guarantee, make sure you have a plan in place for repaying the loan in full and on time. Study the agreement as much as possible before you sign for the loan by taking the following steps:
1. Ask questions about unclear language
First, be wary of ambiguous terms, said attorney Robert DiCuccio of Columbus, Ohio. Ask your lender questions about any language that could be interpreted in more than one way.
“Though a person signing a loan with a personal guarantee may think that they actually understand the contract, the party on the other side of the contract may be interpreting the same word or term to have a completely different meaning,” he said. “A person needs to discuss each term in the personal guarantee to ensure that the parties share a mutual intent as to the effect and meaning of the agreement and its language.”
2. Avoid “continuing guarantees”
Second, look for “continuing guarantee” language that would impact not just that particular loan but future dealings with that particular lender. Approach such agreements with caution and the advice of your lawyer.
Watch for “joint” and “several” language
Third, look for “joint” and “several” guarantees. These clauses make you equally liable as the other business owners who are signing for the loan. The lender could come after you for the full amount of what’s owed even if other partners gave a personal guarantee.
What types of businesses must give a personal guarantee?
There is no single type of business that has to give a personal guarantee. While small businesses and startups are more likely to face personal guarantees, there are no set rules. Credit history and assets are the keys.
How does a personal guarantee affect my credit?
If you default on your business loan and are unable to pay back the lender, it will impact your credit.
Are personal guarantees worth the risk?
Some business owners may deem the benefits of a cash infusion worth the risk of a personal guarantee.
How do I get rid of a personal guarantee?
A personal guarantee may be revoked if the guarantor and lender agree, in writing. It’s also possible that debts enforced by a personal guarantee may be discharged in bankruptcy.